Page 232 - DCOM507_STOCK_MARKET_OPERATIONS

Unit 11: Introduction to Derivatives

Indeed, United Airlines says its 2008 fuel bill is on schedule to hit $9.5 billion if current Notes
prices are sustained. This is more than $3.5 billion higher than last year. Chicago-based
United and other airlines stress that they are under severe financial pressure.
“Since oil prices passed $135 a barrel, jet fuel costs have sent the whole airline industry
reeling,” says a United Airlines spokesman.

United says that 950 pilots, which constitutes about 14% of the total team, will lose their
jobs as spiralling fuel costs, coupled with weak consumer spending, hit earnings.
The job cuts are in addition to existing plans to eliminate 1,600 positions from the firm’s
workforce. Staff numbers must be scaled back as United reduces the number of services it
offers, says the company.

“As we take actions to enable United to compete in an environment of record fuel prices,
we must take the difficult but necessary step to reduce the number of people we have to
run our business,” said the carrier.
However, United Airlines is not alone. Many carriers have made a series of radical moves
to survive, including charging passengers to check in their first piece of luggage and
raising the price of airfare tickets or fuel surcharges.
A number have already collapsed, including UK airline Silverjet and budget carrier Oasis
Hong Kong, while Canada’s leading airline, Air Canada, says it will cut 2,000 jobs by the
end of the year as it reduces capacity to deal with rising fuel costs. Airline giant
Intercontinental also announced 3,000 job cuts in June.
Michael O’Leary, chief executive of budget airline Ryanair, has also warned that most of
Europe’s airlines will go bust if oil prices remain high.

Derivatives – The Solution
The soaring price of oil has clearly taken its toll on the airline industry, but with such a
danger to the market posed by a yet another potential rise in price, the risk management
nature of derivatives may offer an escape from the pain.
“Airlines are definitely trying to minimize uncertainty and volatility,” says Waldron.
Southwest Airlines is one such carrier trying to do all it can to offset the danger poised by
the oil market. The airline says that it has a mixture of “extensive call options, collar
structures and fixed price swaps” to decrease its exposure to jet fuel prices for more than
70% of its remaining 2008 jet fuel needs at an average crude oil equivalent price of about
$51 per barrel.

The company says that it has derivative positions for more than 55% of its anticipated jet
fuel needs for 2009, nearly 30% for 2010, over 15% for 2011 and more than 15% for 2012 at
about $63 per barrel.
It is not just Southwest Airlines that is becoming fully versed in the benefits futures and
OTC derivatives can offer. According to John Heimlich, chief economist at International
Air Transport Association, France-KLM has hedged 75% of its fuel needs for 2008/2009,
while British Airways has about 70% for March to June 2008 and Lufthansa locked in 85%
for 2008. He said that others have been more modest in fuel hedging. For example, Spanish
airline Iberia has hedged 48% of its fuel costs for 2008.

The differing levels of hedging may be explained by some airlines extending their
traditional business areas and getting into a spot of trading themselves. One derivatives
trader believes that some in the airline industry have been making money in oil trading,
which might have been distracting them from their basic business.
Contd...

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